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Oil prices rose about 5 percent last week to finish only a dollar
short of regaining triple-digit status.

Since dipping below $80 per barrel on October 3, West Texas
Intermediate (WTI) prices have increased almost 28 percent. This
increase is nearly twice that of the S&P 500 Index, up 15
percent since October 3, but reinforces a recent trend for oil
prices—as equities go, so goes oil.

This chart put together by the U.S. Energy Information
Administration (EIA), illustrates how WTI crude oil prices and
equities have moved nearly in tandem over the past few months.

The EIA says “the recent strong relationship between oil and
equity prices resembles that seen during the economic downturn
and recovery in 2008-2010.” According to EIA data, crude oil and
the S&P 500 Index have had a positive correlation in 12 of
the past 13 quarters.

A positive correlation had not occurred once in the previous 35
quarters. In fact, crude oil and equities experienced a negative
correlation during five quarters over that time period.

This recent strong correlation implies that equities have the
potential to move higher if oil prices continue along their
current trajectory. Given oil’s current supply/demand
fundamentals, there’s a good chance of that happening.

Demand Holds Strong Despite Global Uncertainty

One of the key drivers for rising oil prices is demand, which has
held steady despite the turmoil in Europe, sluggish economic
growth in the United States and a slowdown in China. In fact,
Citigroup says there is “no indication of a demand collapse
unfolding as in 2008.”

While year-over-year comparisons show global demand growth is
slowing, Citigroup points out that this year’s data compares with
a 2010 period propped up by government policies encouraging
consumption, such as the Fed’s QE2 program. Citigroup says these
comparisons are “obscuring the fact that demand continues to grow
and, barring a sharp derailment of the global economy, is on
course to make a record high in 4Q11 and on an annual basis in
2012.”

By the end of 2012, the EIA forecasts world crude oil and liquid
fuel consumption will total nearly 90 million barrels per day.
This chart from PIRA carries the demand curve further into the
future, forecasting demand to surpass 110 million barrels per day
by 2025.

What is driving this increase? The emerging market transportation
sector.

In its World
Energy Outlook released last week, the Paris-based
International Energy Agency (IEA) says crude oil consumption will
be driven by developing countries over the next 20 years. These
countries will account for 90 percent of the world’s population
growth, 70 percent of the increase in economic output and 90
percent of global energy demand growth over the period from 2010
to 2035.

The agency predicts global crude oil demand will rise to 99
million barrels per day by 2035 “as the total number of passenger
cars doubles to almost 1.7 billion in 2035.” If this prediction
holds true, it means that there will roughly be as many cars in
the world as there were people 100 years ago.

Long-term, Short-term Constraints Threaten Supply

WTI prices have remained in backwardation since shifting from
three years of contango in late October. Contango means that the
price of commodity contracts expiring in the near term is lower
than the forward, future price of crude contracts. Backwardation
is the opposite: The price of a commodity today is higher than
the future purchase price.

While everyday investors may get tripped up by the
contango/backwardation jargon of oil markets, the most important
thing to recognize is that this significant shift signals there
are short-term constraints in supply pushing prices higher. In
fact, crude oil inventories in the United States are now at the
lowest seasonal level in seven years, according to Bank
of AmericaMerrill
Lynch. When the shift occurred, BofA analysts wrote this “is
a major development for the crude oil market” and “signals $105
oil.”

Backwardation is a short-term signal; a long-term signal is the
growing amount of geopolitical unrest bubbling up to the surface
in the world’s largest oil-producing region.
Last week, the International Atomic Energy Agency (IAEA) released
a detailed report that verified many suspicions of nuclear
proliferation in Iran. The IAEA noted it was concerned about
Iran’s “activities related to the development of a nuclear
payload for a missile.”

This news does not sit well with others in the region, such as
Israel, who have threatened military action should the country
deem Iran a security threat. A research note from Barclays
articulates the combustible situation with a quote from Amos
Harel and Avi Issacharoff, writers for Haaretz: “A few more weeks
of tension and one party or another might make a fatal mistake
and drag the region into war.”

War and/or unrest in the region have the potential to have a
tremendous effect on oil prices because of its proximity to the
majority of global oil production. PIRA says that the Middle East
accounts for over 70 percent of OPEC oil production and account
for over 95 percent of the cartel’s capacity growth along with
North Africa.

It’s not only production that is threatened. One of the largest
chokepoints along the global oil supply chain is the Strait of
Hormuz, which roughly 90 percent of all Persian Gulf oil
tankers—some 18 million barrels per day—pass through, according
to Barclays. With Iran controlling the entire northern border of
the strait, there is a significant chance for disruptions should
the country fall into conflict or war.

This is just one example of oil’s geopolitical DNA. With more
than 40 percent of the world’s oil controlled under autocratic
rule, oil supply in democratic nations likely depends on the
state of autocratic nations.

Following the death of Moammar Gaddafi, the Washington Post reports that oil
companies are eager to begin pumping oil in Libya again but the
new regime is still battling Gaddafi supporters and the country
is a long way from being unified. Barclays notes several
concerns: oil fields need to be repaired, Interim Transitional
National Council has experienced growing factions, and there’s
been a proliferation of weapons.

There’s also sanctions and persistent violence in Syria. In
Yemen, an oil export pipeline was blown up a couple of weeks ago,
making it the fifth attack in just a month. Barclays indicated
that “almost half of Yemen’s 260,000 barrels per day of oil
output has been offline since March” and it doesn’t look like the
situation will improve any time in the near future.

Trends in Demand and Supply Maintain Pressure on Prices

While BofA analysts think that oil prices could be headed toward
$105 per barrel in the short term, the IEA offered a longer-term
view that should give natural resources investors calm for many
years to come.

The IEA says “trends on both the oil demand and supply sides
maintain pressure on prices. We assume the average IEA crude oil
import price remains high, approaching $120 per barrel (in 2010
dollars) in 2035 (over $210 per barrel in nominal terms).”

That’s a distant projection but it certainly illustrates why you
should consider investing a portion of your wealth in oil.

All opinions expressed and data provided are subject to change
without notice. Some of these opinions may not be appropriate to
every investor. The S&P 500 Stock Index is a widely
recognized capitalization-weighted index of 500 common stock
prices in U.S. companies.

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securities mentioned in this article as of September 30, 2011.